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Expected Credit Loss (ECL)-based loan loss provisioning framework

  • May 17, 2023
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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Expected Credit Loss (ECL)-based loan loss provisioning framework

Subject : Economy

Section: Monetary Policy

Concept :

  • Banks have requested the RBI for one more year’s time to implement the system of Expected Credit Loss (ECL) for provisioning of loans.

Background

  • In January 2023, the RBI came out with a draft guideline proposing adoption of expected credit loss approach for credit impairment.
  • It said the banks will be given a one-year period after the final guidelines are released for implementation of new framework.
  • RBI is yet to announce the final guidelines on ECL norms.
  • However, some of the rating agencies have said that final norms on this may be notified by FY2024 for implementation from April 1, 2025.

Loan-loss provision

  • The RBI defines a loan loss provision as an expense that banks set aside for defaulted loans.
  • In other words, a loan loss provision is a cash reserve that banks set aside to cover losses incurred from defaulted loans.
  • Basically, it is an income statement expense banks can tap into when borrowers are unlikely to repay their loans.
  • In the event of a loss, instead of taking a loss in its cash flows, the bank can use its loan loss reserves to cover the loss.
  • The level of loan loss provision is determined based on the level expected to protect the safety and soundness of the bank.

Present Approach

  • Banks in India are currently required to make loan loss provisions based on incurred loss model.
  • This model assumes that all loans will be repaid until evidence to the contrary (known as a loss or trigger event) is identified.
  • Only at that point is the impaired loan (or portfolio of loans) written down to a lower value.

Problem with the incurred loss-based approach

  • The incurred loss approach requires banks to provide for losses that have already occurred or been incurred.
  • The delay in recognising expected losses under this approach was found to exacerbate the downswing during the financial crisis of 2007-09.
  • Faced with a systemic increase in defaults, the delay in recognising loan losses resulted in banks having to make higher levels of provisions.
  • This ate into the capital maintained by the bank which in turn affected banks’ resilience and posed systemic risks.
  • Further, the delays in recognising loan losses overstated the income generated by the banks.
  • This, coupled with dividend payouts, impacted their capital base because of reduced internal accruals — which too, affected the resilience of banks.

Expected Credit Loss (ECL) for provisioning of loans

  • RBI has proposed a framework for adopting an expected loss (EL)-based approach for provisioning by banks in case of loan defaults.
  • Under this practice, a bank is required to estimate expected credit losses based on forward-looking estimations.
  • Under this, banks will need to classify financial assets into one of three categories — Stage 1, Stage 2, or Stage
  • This classification will depend upon the assessed credit losses on them, at the time of initial recognition as well as on each subsequent reporting date, and make necessary provisions.
economy Expected Credit Loss (ECL)-based loan loss provisioning framework
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